Fannie, Freddie Shares Plunge as Unease Rises
Talk of Federal Bailout Sparks Sell-Off

By David S. Hilzenrath and Jeffrey H. Birnbaum
Washington Post Staff Writers
Friday, July 11, 2008

Shares of Fannie Mae and Freddie Mac, two pillars of the nation's housing market, continued to plummet yesterday as investors and federal officials contemplated the possibility that the giants of the mortgage business could require a federal bailout.

On Capitol Hill, the Treasury secretary offered reassurance that they are still on firm footing, and the Senate moved on a housing relief bill that would give a regulator more power over them. On the campaign trail, the presumptive Republican presidential nominee vowed to do whatever is necessary to keep the companies functioning. In the financial world, some people had concluded that a painfully expensive rescue was probable, while others said it was unlikely. The speculation was taking on a life of its own, feeding a downward spiral.

Analyst Howard Shapiro of the investment research firm Fox-Pitt Kelton wrote that the prospect of the Washington area companies becoming insolvent was remote, but he added, "[W]e cannot account for the psychological impacts of this kind of talk, which can create its own reality."

On one point there seemed to be general consensus: The failure of Fannie Mae or Freddie Mac could be devastating, making it harder for people to buy and sell homes and sending ripple effects through the broader economy.

The meltdown of the mortgage business has left Fannie Mae and Freddie Mac the main sources of funding for mortgage lenders. The companies, which were chartered by the federal government to keep those funds flowing, pool mortgages into securities for sale to investors, guaranteeing that they will cover the payments if borrowers default. They also buy and hold mortgage investments.

Although the companies and the federal government deny it, the financial markets have long assumed that the government would step in to cover the companies' trillions of dollars of obligations if they were unable to do so themselves. The belief that the government stands behind them helps explain why Fannie Mae and Freddie Mac have historically been able to borrow money at low rates -- and why the demand for their mortgage securities did not dry up as investors abandoned other mortgage-related investments.

But confidence in the companies has eroded sharply this week. Fannie Mae stock tumbled nearly 14 percent yesterday, to close at $13.20, its lowest price in many years. Freddie Mac stock fell 22 percent, to $8; its shares have lost nearly 90 percent of their value during the past year.

Yesterday's sell-off came against the backdrop of jarring news reports. Bloomberg News quoted William Poole, former president of the St. Louis Federal Reserve, saying that the two companies were already insolvent. The Wall Street Journal reported that the Bush administration had stepped up routine planning as to what to do if either company failed, though the Journal said the administration did not expect that to happen.

Spokesmen for the White House and the Treasury Department declined to comment yesterday on any such planning, and Freddie Mac spokeswoman Sharon McHale said her company had not been involved in any such discussions. A Fannie Mae spokesman wouldn't comment on that topic.

"We are managing our business and maintaining a capital position that will allow us to fulfill our congressionally chartered mission now and in the future," Fannie Mae spokesman Brian Faith said in a statement.

As mortgage defaults have risen and home prices have fallen, the companies have reported billions of dollars of losses. They have also reported billions of dollars of unrealized losses -- paper losses that they have not included in their bottom line because they predict asset values will rebound. Freddie Mac reported that if it had been forced to liquidate its holdings at the end of the first quarter, it would have been left with a deficit of $5.2 billion.

If Fannie Mae and Freddie Mac faltered, mortgage interest rates could soar and home prices could suffer even greater declines. Many banks are sitting on large amounts of the bonds Fannie Mae and Freddie Mac issue to borrow money, and damage to the value of those bonds could indirectly undermine banks' ability to make loans of all kinds.

With the housing market in continued decline, many investors think Fannie Mae and Freddie Mac will need to raise fresh capital. That expectation has put downward pressure on their stock prices because selling more shares to raise money dilutes the value of current shares.

Peter Schiff, president of Euro Pacific Capital, predicted that the companies would have a hard time raising capital from private sources. "That's like selling tickets for the Titanic after it's already hit the iceberg," he said.

Government leaders, including those at the Federal Reserve, take some solace in the large holdings of mortgage assets that the two firms have on their books. But selling those assets -- home loans and mortgage-backed securities -- could drive up mortgage rates, former Treasury official Peter Wallison said.

Short of lending them money or taking them over, one way the government could shore up faith in the companies would be to state explicitly that it stands behind them. However, that would run counter to the administration's long-standing position that companies must be held accountable to the market's checks and balances. Treasury Secretary Henry M. Paulson Jr. reiterated that philosophy in prepared testimony yesterday, saying: "For market discipline to be effective, market participants must not expect that lending from the Fed, or any other government support, is readily available."

Sen. John McCain, the presumptive Republican nominee for president, sent a different message. Fannie Mae and Freddie Mac "must not fail," he said, adding, "I will be looking at all the options that are, will be necessary" to keep them viable.

McCain said he didn't think a bailout was required, and Paulson noted that the companies' regulator "has made clear that they are adequately capitalized."

Fannie Mae and Freddie Mac tried to turn investors' anxiety to their political advantage, lobbying to make the housing relief bill that is moving through Congress more favorable to their interests.

Staff reporters Michael Fletcher, Neil Irwin, Michael Shear and Mike Shepard contributed.

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